How VC Bleed You of Equity

06/28/2017By Sammy Abdullah, CFA

When is a term sheet with a $10mm valuation not really a $10mm valuation? When certain structural components are added. Below are two ways VC can bleed you of equity:

Participating preferred stock. Traditional preferred stock is usually non-participating with a 1.0x preference. In English, that means should things go terribly, the investors who own preferred stock get their money back first and founders/common stock share in whatever is left over. It’s a reasonable ask in our view given that it’s intended as down side protection only. Where it becomes abusive is when it’s participating preferred, meaning the preference is used to juice the upside as well. In that scenario, the VC get their money back first AND share in whatever is left over – VC would get paid first in an upside scenario as well in that case which is like getting free equity. Below is a table showing the percent reduction in value to the common stock/founders based on dollar amount of investment in participating preferred equity and the value at exit.

Valuation at Exit

$10,000,000

$15,000,000

$20,000,000

$25,000,000

$30,000,000

$35,000,000

$40,000,000

$45,000,000

$2,000,000

20%

13%

10%

8%

7%

6%

5%

4%

$4,000,000

40%

27%

20%

16%

13%

11%

10%

9%

$6,000,000

60%

40%

30%

24%

20%

17%

15%

13%

$8,000,000

80%

53%

40%

32%

27%

23%

20%

18%

Investment

$10,000,000

100%

67%

50%

40%

33%

29%

25%

22%

$12,000,000

---

80%

60%

48%

40%

34%

30%

27%

$14,000,000

---

93%

70%

56%

47%

40%

35%

31%

$16,000,000

---

---

80%

64%

53%

46%

40%

36%

$18,000,000

---

---

90%

72%

60%

51%

45%

40%

$20,000,000

---

---

100%

80%

67%

57%

50%

44%

Dividends. Dividends are a relic of private equity investing. Although they’re non-cash so they won’t drain the bank account, dividends accrue in equity. For instance, a 7% dividend turns 100 shares into 121 shares in 3 years resulting in a 21% increase in equity to an investor. That additional equity is at the expense of investors in common stock/founders who do not have a dividend, so the result is a gradual but meaningful transfer of ownership to investors. Sometimes, dividends are payable only “if and when they’re declared by the board” so many founders think so long as the board doesn’t declare dividends, they’ll be protected. However, if at exit the board is investor controlled, sometimes they’ll retroactively declare all past due dividends. You should always push back on the dividend when you can.

Dividend

5%

6%

7%

8%

9%

10%

Year 1

5%

6%

7%

8%

9%

10%

Year 2

10%

12%

14%

16%

18%

20%

Year

Year 3

15%

18%

21%

24%

27%

30%

Year 4

20%

24%

28%

32%

36%

40%

Year 5

25%

30%

35%

40%

45%

50%

Look for VC that have very straightforward, easy to understand market terms. If you see things like participating preferred stock or dividends, just know that if you take that deal, the valuation you’re being quoted isn’t really the valuation the VC will ultimately enjoy at exit given some of these structural enhancements to their preferred stock.